Wag the dog

Investment Strategy Problem #3 in Retirement – Don’t Let the Tax Tail Wag the Dog!

In the last few editions of RETIREMENT GAME PLAN, I’ve revealed an incredible statistic reported by DALBAR, Inc., a Boston based research firm which revealed that while the S&P 500 Stock Market index earned 9.96% per year over the last 30 years, the average stock mutual fund investor earned only 5.04% per year over those same 30 years, nearly 50% less!

Since then, I’ve revealed (2) big reasons why this is the case.

One of our Relaxing Retirement Members asked me why I keep outlining all of these mistakes.  It’s a very perceptive question!

The reason is simple.  If you listen to the mainstream financial media “marketing machine,” who has goals which are in direct conflict with your goals, you might be led to believe that markets (up, down, and sideways, etc.) dictate our real life investment returns.  (That’s why they spend so much time every day talking about market returns.)

If that was true, then we’d each earn whatever the market produced.  Well, we all know that’s not the case.  As the DALBAR, Inc. report pinpoints, the average stock mutual fund investor earned 50% less each year than the broad market index over the last 30 years.  50% less! 

The reason I continue to point out the “behavioral” mistakes individuals made that led to this catastrophic result is so you can potentially avoid them, and increase your chances of earning the higher expected returns you need to earn in order to experience total financial independence and live the life you’ve earned.

The key point is that each of these mistakes is within our control to avoid.

Let’s take a look at another costly mistake we see way too often which leads to these awful results!

Letting the Tax Tail Wag the Dog

Let me explain what I mean by walking you thru a real-life Case Study of an employee of GE:

  • Charlie was an employee of GE for 42 years
  • He purchased GE stock shares through payroll deduction during entire career
  • As a result of purchases and stock splits, when Charlie retired in January 2002, he owned 5,100 shares!
  • At $315 per share, the value of his shares was a little more than $1,600,000
  • What’s important to note is that these GE shares represented 63% of Charlie’s investment holdings! 
  • The next important fact was that his cost basis in the GE shares (i.e. what he paid for them) only $80,000

Question #1 to Contemplate: Is it a good idea for Charlie to have 63% of his investments tied up in any one stock?

Question #2: If Charlie had $1.6 million in cash today, should he buy $1.6 million of GE stock?

Question #3: If the answer is no, why would Charlie then hold on to them and not diversify?

The Answer: Taxes!

Because his cost basis was only $80,000, if he sold the shares back in 2002, he would have paid approximately $304,000 in federal capital gains taxes and walked away with $1,296,000.

As is common for a very good reason, Charlie’s focus was on the $304,000 he had to pay to free up the money and diversify.

He would have been far better off focusing on the fact that he had to part with 19% in order to free up the other 81%.  It sounds a lot better. 

So, what did Charlie do?

Like the overwhelming majority of people, Charlie hung on to the GE shares to avoid paying any taxes.    

Now, let’s take a look ahead to today and see how good of an idea that was.

  • If Charlie sold the shares back in 2002, paid the tax, and reinvested the remaining $1,296,000 in a generic and simple S&P 500 Index Fund, and allowed dividends to reinvest from January 2002 through December, 2020, the value would have grown to approximately $5,951,695 by the end of 2020.

Let’s now look at where Charlie was at the end of 2020 since he didn’t sell his GE shares back in 2002 in order to avoid paying taxes.

  • If he continued to hold GE shares, including reinvesting the dividends, on December 31, 2020, his shares were worth $769,120.

To recap, had he sold his GE shares, paid the taxes, and reinvested, he would have had $5,951,695 at the end of 2020.

However, because he let taxes drive his investment decision back in 2002, he had $769,120 (the value of his GE shares at the end of 2020 including reinvestment).

The “Cost” of Letting the Tax Tail Wag the Dog

If you do the math, that’s $5,182,575 that Charlie lost because he “Let the Tax Tail Wag the Dog” instead of using sound, rational judgment.

Charlie focused on the dollar amount that he had to pay in taxes which was over $300,000.  I completely agree that’s no fun (and the fairness of it is another topic we won’t touch today). 

However, by focusing on that dollar cost, he drastically increased his risk and lost over $5 million!

This is a classic example that I’ve personally witnessed time and time again.  And, it’s one of the great lessons of why the average investor not only doesn’t beat market averages, but instead, as statistics have now shown, has earned a very costly 50% less.

Stay out of the trap!  Before making any investment decisions, you must evaluate the tax consequences and the investment consequences simultaneously!

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